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Financial Regulation, Monetary Policy, and Inflation in the Industrialized World

Massachusetts Institute of Technology (MIT) - Department of Political Science

The Journal of Politics, Vol. 70, No. 3, pp. 663-680, July 2008

Abstract:

This article argues that the institutional mandates of central banks have an important influence on inflation outcomes in the advanced industrialized countries. Central banks that are also responsible for bank regulation will be more sensitive to the profitability and stability of the banking sector and therefore less likely to alter interest rates solely on the basis of price stability objectives. When bank regulation is assigned to a separate agency, the central bank is more likely to enact tighter monetary policies geared solely toward maintaining price stability. An econometric analysis of inflation in 23 industrial countries from 1975 to 1999 reveals that inflation is significantly higher in those countries with central banks that are vested with bank regulatory responsibility, although this effect is conditional on the choice of exchange rate regime and the relative size of the banking sector. We also conduct a case study of the Bank of England, which lost its bank regulatory authority to a new agency in 1998. We find that the new Labour government under Tony Blair imposed the institutional change on the Bank of England in part to remove the bank stability bias from its monetary policymaking. These findings suggest that the mandates of central banks not only have important influences on macroeconomic outcomes, but may also be modified in the future by governments seeking to impose their own monetary policy preferences.